Hedge Fund Clones: Are They As Good As the Real Thing?

Hedge fund clones enjoy lower fees and higher liquidity, along with a host of limitations, a paper explains.

(October 17, 2012) — When you think of “clones,” pictures of sheep, mice, and babies may come to mind…hedge funds are likely not in that thought bubble.

But a newly released paper delves into what drives the appeal and drawbacks of hedge fund clones, which “rely more on synthetic instruments than the hedge funds they track.”

While the liquidity and lower fees of clones make them attractive, they cannot capture all the alphas of hedge fund managers because they react with a lag, assert the authors Arik Ben Dor and Zhu Xuof of Barclays, Ravi Jagannathan, a professor of finance of Northwestern University, and Iwan Meier, a professor at HEC Montréal. “This limitation will be accentuated during fast-changing market conditions, and the recent financial crisis provides a natural setting for evaluating the tradeoff between the increased liquidity and transparency of hedge fund clones, on the one hand, versus their inability to fully capture the alphas of hedge funds, on the other hand,” according to the paper.

During the recovery period following the crisis (from March 2009 to April 2010), an equal-weighted index of clones offered by six sell-side firms with representing assets under management of about $2.5 billion to $3 billion –underperformed by 0.70% per month. The authors consider the following three alternative explanations for this performance pattern:

1) Poorly performing hedge funds may not be fully accounted for due to the self-reporting bias;

2) tracking errors are related to changes in market-wide liquidity levels as measured by the basis between derivatives and cash securities; and

3) the benchmark methodology, equally weighted versus asset weighted, perturbs the performance assessment.